In the scenario you've described, Company A purchases machinery from Company B and has been using it for three years, with a useful life of 5 years according to Company A's management policy. You're seeking clarification on the depreciation treatment as per the Income Tax Act (IT Act) and how to potentially manage depreciation for tax purposes.
Let’s break it down and address your questions one by one:
a) Should we now account for the depreciation for 2 years only as per the IT depreciation rate?
Depreciation under the Income Tax Act (IT Act) is generally allowed based on the written down value (WDV) of the asset and the prescribed depreciation rates under the act, rather than the asset's useful life as per management’s policy. The key point here is that the Income Tax Act does not directly consider the company’s internal policies for useful life but instead uses the statutory depreciation rates based on the asset’s category.
In your case, since Company A has already been using the machinery for three years, the WDV of the asset will be the base for calculating depreciation going forward under the IT Act. The important thing to note is:
- Depreciation is calculated on the WDV of the asset, not the total useful life as per internal policies.
- Since Company A has already used the machinery for 3 years, the depreciation will be calculated based on the WDV at the start of the 4th year of usage (the current year's depreciation).
- The asset may have already been depreciated for 3 years under the IT Act, and in the 4th year, Company A would continue depreciation based on the WDV of the asset as at the beginning of the current year.
So, Company A should account for depreciation from the 4th year onward based on the remaining WDV and the applicable IT Act depreciation rate, not just for 2 years (unless the asset is being sold or disposed of).
b) What can be the other possible ways to harvest tax if we want to keep account for depreciation for 5 years under the IT Act?
If you want to extend the depreciation period under the IT Act and potentially continue depreciation for a full 5 years, here are a few possibilities:
- Opt for the "Block of Assets" Approach: Under the IT Act, machinery is usually depreciated under the block of assets method. Instead of depreciating individual assets separately, assets of similar nature and use are grouped into blocks, and depreciation is calculated on the total value of the block, not on individual assets. Therefore, if machinery is part of a block, it may not matter if individual assets have different useful lives.
- If the machinery purchased by Company A is part of a block of assets that includes other machinery with a similar useful life, the overall depreciation can continue based on the block's WDV.
- Use of Accelerated Depreciation: Depending on the classification of the asset under the Income Tax Act, certain types of machinery may be eligible for higher depreciation rates under specific sections, such as Section 32. Some machinery might qualify for higher depreciation rates (like 40% or 15% depending on its class).
If the machinery is eligible for accelerated depreciation (perhaps in certain sectors like manufacturing), this could help offset taxes more quickly in the initial years. However, this doesn’t extend the useful life to 5 years but may maximize tax deductions early on.
- Section 35AD – Investment-linked Deduction: Under Section 35AD of the IT Act, certain capital expenditures (for setting up specific business activities like infrastructure or manufacturing units) can be fully depreciated in the year of acquisition. If your machinery is being used for such activities and meets the criteria, you might be able to claim a 100% depreciation in the first year (although this doesn’t spread depreciation over 5 years, it can reduce tax significantly in the first year).
- Writing Off the Asset as a Capital Loss: If Company A decides to sell or dispose of the machinery after a few years, and if the machinery is no longer in use or its market value has diminished, you may be able to write off the loss on sale of the asset. This could potentially be used to claim a loss under the IT Act and help offset taxable income.
- Opt for a Revaluation of the Asset: In some cases, companies opt for a revaluation of their assets to reflect a higher value, which could increase depreciation claims. However, this approach is typically less common for tax purposes as it can lead to complications, and the IT Act generally follows the historical cost method for calculating depreciation. So, this would require careful consideration and likely won't allow extending the depreciation period directly.
- Capitalizing the Cost of Improvements or Additions: If you incur additional costs to improve the machinery (such as upgrading or enhancing its capabilities), you could potentially capitalize these costs and claim depreciation on the added value under the IT Act. However, this only extends the depreciation on the improvement part, not the original asset.
Summary
- For accounting depreciation under the IT Act, Company A should continue depreciating the machinery based on the WDV from the 4th year onwards, using the applicable depreciation rate. The useful life as per management policy does not directly affect tax depreciation.
- To maximize tax benefits while adhering to the IT Act, Company A could consider:
- Grouping the asset into a block of assets with similar assets.
- Seeking accelerated depreciation if applicable.
- Exploring options like Section 35AD or full depreciation in specific cases.
However, since tax planning can be complex, it would be advisable for Company A to consult a tax advisor or CA to tailor strategies to their specific situation and business structure.
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